The Fed's Mixed Bag of Measures

The Fed announced more “emergency” measures Sunday, just three days before its scheduled meeting and monetary policy announcement, and markets reacted fearfully. In addition to cutting the fed-funds target range by a full percentage point to 0 – 0.25%, the bank restarted its “quantitative easing” (QE) asset purchases: “Over coming months the Committee will increase its holdings of Treasury securities by at least $500 billion and its holdings of agency mortgage-backed securities by at least $200 billion.”^[i] In hopes of boosting liquidity in financial markets, they also dropped the discount rate (at which banks borrow from the Fed directly) to 0.25%, dropped reserve requirements to 0 and encouraged banks to draw on their capital buffers, if necessary, to boost lending to households and businesses short on cash as COVID-19 containment policies escalate. While they likely intended to shore up confidence in the banking system and allay fears of a financial crisis, the move seems to have done the opposite, giving investors the perception the Fed knows something the rest of us don’t. To us, that is more panicky sentiment than reality, though to be clear, the Fed can’t do anything to stop the economic consequences of COVID-19 containment efforts. They can only help with the collateral damage and the eventual recovery, and on that front, these measures are a mixed bag.

Starting with the good, the measures to ensure liquidity are fine in theory, although the announcement’s timing and sentiment probably did more harm than good in the very short term. Oodles of small businesses have been forced to close, and no one wants to see restaurants, breweries, shops, daycare centers, dental offices and others have to fold just because revenues stopped rolling in and they couldn’t cover fixed costs. That would be astounding collateral damage. So to the extent that the Fed can grease the financial system to enable banks to get folks over the hump, good.

But only time will tell whether these policies work in the real world as well as in theory. Letting banks take capital below regulatory minimums sounds helpful, but banks were already holding capital well above the minimum, suggesting regulations alone don’t guide their capital decisions. Similarly, the Fed encouraged banks to use the discount window on Monday, in an effort to erase the stigma that has long accompanied it. Fair enough, but what practical reason do banks have to tap the discount window when the rate is higher than what they would find in the open market? The Fed historically encouraged discount window use by dropping the discount rate below fed-funds to boost liquidity. That enabled banks to borrow from the Fed and lend to each other at a small profit—a powerful incentive. They didn’t use that tool in 2008 and aren’t now, which is a bit head-scratching. We suspect it is all fine since banks actually have plenty of cash, but still.

Our biggest beef is with QE. Long-term asset purchases have two aims. One, flood banks with reserves—seemingly unnecessary now, based on the last tally of banks’ excess reserves. Two, reduce long-term interest rates—also seemingly unnecessary, considering long-term Treasury and mortgage rates are at historic lows. Investment-grade corporate bond rates are up, but only to levels seen last July.^[ii]

Lower long rates might help stimulate demand for fixed income, which is the aim. But by restarting QE, the Fed is taking actions that flatten the yield curve. The big fed-funds rate cut helps offset that to an extent, at least for now, but there is a risk QE prevents the curve from steepening as much as it otherwise would when the recovery gets going. That happened for years during the expansion that began in July 2009. Loan growth and broad money supply growth were slower in the expansion’s first few years than in all other post-WWII expansions. We aren’t saying the same thing will happen this time, but it does seem counterproductive for the Fed to announce a bunch of liquidity measures and then take measures to flatten the yield curve. Especially when there is a lot of evidence this Fed, unlike its predecessors, is watching the yield curve closely.

Yield curve concerns aside, we do think it is noteworthy that central banks globally are pumping liquidity. There is also a growing swell of fiscal stimulus. That won’t help turn the tide. But whenever COVID-19 fades, whether with normal flu season in a few weeks or later, and life goes back to normal, we think the added liquidity and fiscal pump-priming should help money move through the economy swiftly, helping people everywhere unleash the demand pent up by a few weeks of quarantines and closures. It doesn’t help in the here and now, and stocks don’t need stimulus or anyone to come and rescue them. But perhaps knowing a tailwind lurks nearby can be a silver lining today.